Problem:
Let's assume a severe recession hits. The nominal risk free rate on the 10-year treasury bond falls to 1.00% from the current 2.31% rate (as of 11/7/2014). Assume Badger Meter issues new 10-year bonds as part of a recapitalization. During a recession, the default risk premium (DRP) and liquidity premium (LP) will likely rise. Badger Meter's DRP will rise even more if its debt to equity ratio rises, as it will during this recapitalization.
Required:
Assume the DRP on the new bonds is 3.5%, and the LP is 2.0%. Ignore the maturity risk premium. What is the before-tax cost of Badger Meter's new 10-year bonds?
a) 3.50%
b) 4.31%
c) 5.50%
d) 5.81%
e) 6.50%
f) 7.81%
Note: Please provide through step by step calculations.